Not enough safety margin

Automatic data processing (ADP) provides cloud-based human capital management solutions worldwide. The company has solid fundamentals that allow it to create value for its shareholders.

Additionally, its trading risk profile is relatively safe compared to most of its peers. However, we are currently neutral on the stock.

ADP creates shareholder value

If profitability is what determines the viability of a company, not all profitability is synonymous with the creation of shareholder value. Therefore, we like to use economic allocation to determine if a company is efficiently allocating capital to its projects. The formula is:

Economic distribution = Return on invested capital – Weighted average cost of capital

The idea is very simple; if the return on invested capital is higher than the cost of this same capital, then the company creates value for its shareholders through well thought out projects. Otherwise, the company is destroying value and would be better off just investing the money in risk-free bonds.

For ADP, the economic spread is as follows:

Economic spread = 32.3% – 6.8%

Economic spread = 25.5%

As a result, the company creates value for its shareholders, which requires management to allocate capital efficiently.

However, what is more important than the current economic breakdown are the company’s financial trends. ADP has seen steady growth in its free cash flow over the past few years.

In 2018, this figure was $2.31 billion, and then increased to $2.53 billion, $2.85 billion, and $2.91 billion in 2019, 2020, and 2021, respectively.

In addition, gross margins have remained relatively stable over the past few years, hovering between 43.3% and 45.3% since 2017. This suggests that the business is stable and predictable, and that the competition is not eating away at its margins. .

Risks

To measure the risk of automatic data processing, we will first check whether financial leverage is an issue. To do this, we compare its debt to free cash flow. Currently, this number is 1.14.

Overall, we don’t think debt currently poses a material risk to the business as its interest coverage ratio is 53x (calculated as EBIT divided by interest expense).

However, there are other risks associated with automatic data processing. According to TipRanks’ risk analysis, ADP disclosed 15 risks in its latest earnings report. The highest risk level came from the Tech & Innovation category.

Nonetheless, the total risk count for ADP is below the industry average, making it potentially safer on a relative basis compared to most of its peers.

The Taking of Wall Street

On Wall Street, Automatic Data Processing has a consensus holding rating, based on two buys, seven takes and no sell ratings given in the last three months.

The average ADP price target of $228 implies 10.5% upside potential.

Final Thoughts

ADP is a profitable company that creates value for its shareholders through growing cash flow. Moreover, its risk profile is below the industry average and analysts expect it to rise further from its current levels.

That being said, the 10.5% upside target does not provide enough of a safety margin to make us bullish on the stock. This is especially true as the stock is currently on a downtrend, and we would like to see a clear trend reversal before we jump in. We are therefore neutral.

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